Focus on Not-For-Profits: Alternative Investments & Unrelated Business Income

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Over the past two decades, many not-for-profit organizations, including foundations and endowment/investment funds, have begun investing more regularly in alternative investments. Alternative investments are defined for financial reporting purposes as investments for which a readily determinable fair value does not exist.

February 22, 2013

Over the past two decades, many not-for-profit organizations, including foundations and endowment/investment funds, have begun investing more regularly in alternative investments. Alternative investments are defined for financial reporting purposes as investments for which a readily determinable fair value does not exist. Examples include hedge funds, private equity funds, real estate funds, venture capital funds, commodity funds, offshore fund vehicles, and funds of funds.

While it is generally permissible for not-for-profit organizations to invest in alternative investments, it is important to understand the related tax reporting requirements and the exposure to unrelated business income (UBI) that can result from such investments. This article will discuss the implications of these tax issues.

Generally, there are two investment practices utilized by alternative investment funds that could generate UBI for organizations investing in the funds. The first practice occurs when the fund is leveraged—that is, the fund incurs debt and utilizes the proceeds to purchase assets. The second, and more common, practice occurs when the fund operates a for-profit business, either independently or as a part-owner. Even if the not-for-profit organization does not directly operate a for-profit business, by virtue of owning an interest in the alternative investment fund, the not-for-profit is exposed to UBI on its proportional share of the earnings generated by the business operated by the alternative investment fund. To the extent that this UBI cannot be offset by related expenses, the not-for-profit will have to pay unrelated business income tax.

Not-for-profit organizations investing in an alternative investment fund may receive an annual Form K-1 from the fund if the fund is classified as a partnership. It is important for not-for-profit organizations to review this form very carefully to determine whether the fund generates UBI. In particular, the following should be reviewed:

Box 1 – Ordinary business income (loss) – If there is an amount in this box, it means that the fund has operated some type of for-profit business, and the amount reported represents the not-for-profit organization's share of the income.

Box 20V – Unrelated business taxable income – This box indicates the amount of taxable UBI for the organization. Typically, funds that report taxable UBI include oil and gas operations and hedge funds that classify themselves as being in the business of trading securities.

The footnotes to the K-1 – Some funds will disclose percentages to apply to income reported elsewhere in the K-1 to determine the amount of taxable UBI for the nonprofit entity.

If a not-for-profit organization has UBI, it must be reported on Form 990-T, which is filed separately from the organization's Form 990, 990-EZ or 990-PF. If the UBI calculation on the Form 990-T results in more than $1,000 of taxable net income, the not-for-profit organization must pay tax on this at regular corporate or trust income tax rates. If the UBI calculation results in a loss, it is recommended that a Form 990-T still be filed in order to capture the losses to be carried forward and offset against any UBI reported in future tax years, or carried back to refund any prior year taxes paid. Additionally, in most states, the not-for-profit organization will also have to file a state income tax return.

Also, it should be noted that investments in alternatives and foreign markets can be structured in one of two ways: either directly or through an indirect, pooled investment such as a fund of funds. In recent years, foundations and endowments generally have moved toward being direct investors, shifting away from the use of funds of funds as their major investment vehicle. Either method can result in domestic and foreign tax liabilities. However, in some instances, the use of blocker corporations can reduce UBI exposure. In this case, a separate entity is created that invests in the alternative or foreign investment and pays domestic dividends from its after-tax income to its shareholders, which may be include tax-exempt entities. This generally eliminates the pass-through business income that would be reported on a K-1 to the not-for-profit organization, thus eliminating any related UBI.

Finally, special consideration needs to be given to foreign investments. If these investments are valued at $100,000 or more, then the not-for-profit organization will need to complete Schedule F, Parts I and IV when filing its Form 990. Tax-exempt organizations, including private foundations filing Form 990-PF, may also be required to complete one or more foreign disclosure filings, such as Form 926 (for foreign corporation investments) or Form 8865 (for foreign partnerships). Failure to do so could result in significant penalties. These filing requirements can also apply to indirect investments through blocker corporations or pooled investments such as funds of funds that invest in foreign markets, as described above. Reporting requirements for Form 926 and Form 8865 may arise even in cases where Form 990, Schedule F is not required.

Alternative investments are pursued by many not-for-profit organizations in order to increase investment return and diversify investment portfolios. However, as can be seen from the preceding discussion, alternative investments may also involve tax liability exposure and/or additional filing requirements. Accordingly, we recommend that not-for-profit organizations ensure they are familiar with each of their alternative investment funds, including their underlying investment strategies and activities and the related tax consequences.

Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.